1

The Goals and Activities of

Financial Management
Block, Hirt, and Danielsen
Foundations of Financial Management
17th edition

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
• The field of finance integrates concepts from economics,
accounting, and a number of other areas.
• A firm can have many different forms of organization.
• The relationship of risk to return is a central focus of finance.
• The primary goal of financial managers is to maximize the
wealth of the shareholders.
• Financial managers attempt to achieve wealth maximization
through daily activities such as credit and inventory
management and through longer-term decisions related to
raising funds.
• The financial turmoil that roiled the markets between 2001
and 2012 resulted in more regulatory oversight of the
financial markets.
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-2
 The Field of Finance

• Economics provides broad pictures of

economic environments for decision making
• Accounting provides financial data through:
• Income statements
• Balance sheets
• Statement of cash flows
• Finance links economic theory with
accounting numbers

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-3
 Evolution of the Field of Finance

• 1900s—Finance emerges as separate field

from economics
• 1930s—Financial practices revolve around
such topics as
• Capital preservation
• Maintenance of liquidity
• Reorganization of financially troubled corporations
• Bankruptcy process

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-4
 Evolution of the Field of Finance
Continued
• 1950s—Finance becomes more analytical
• Financial capital (money) used to purchase real
capital (long-term plant and equipment)
• Cash and inventory management
• Capital structure theory
• Dividend policy
• Financial manager making day-to-day decisions

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-5
 Modern Issues in Finance

• Focus has been on

• Risk-return relationships
• Maximizing return for given risk level
• Portfolio management
• Capital structure theory
• New financial products focusing on hedging
are now widely used
• Reducing risk by changing interest rates

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-6
 Modern Issues in Finance
Continued
• Inflation (increase of prices)—key variable in
financial decisions
• Disinflation (a slowing down of price
increases)
• Significant factors during decision making
• Effects of inflation/deflation on financial forecast
• Required rates of return for capital budgeting
decisions
• Cost of capital
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-7
 Risk Management and a
Review of the Financial Crisis
• Reasons for recent financial crisis
• Extension of credit to high-risk borrowers
• Creation/sale of mortgage-backed securities
• Losses from credit defaults in excess of banks’
capital in many cases
• Creation of complicated, unregulated financial
products like credit default swaps (CDS)
• Government action and bail-outs
• Federal Reserve money
• New regulations for financial institutions
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-8
 The Impact of the Internet

• Internet accelerates e-commerce solutions for

“old economy” companies
• E-commerce solutions for existing companies
• Business to consumer (B2C)
• Business to business (B2B)
• Creation of new business models and companies
• Amazon.com and eBay (retail)
• Facebook and Twitter (social media)
• Netflix and Google (entertainment & information)

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-13
 The Impact of the Internet
Continued
• E-commerce affects pattern and speed with
which cash flows through firms
• B2C model
• Orders placed with credit cards
• Selling firms get cash flow faster
• New ways to reach customers
• B2B model
• Lower cost of managing inventory, accounts receivable,
cash
• Efficient way to interact with suppliers

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-14
 Activities of Financial Management

 Financial management concerned with

managing entity’s money
 Functions
• Allocate funds to current and fixed assets
• Obtain best mix of financing alternatives
• Develop appropriate dividend policy within
context of firm’s objectives
• Day-to-day credit management, inventory control,
and receipt and disbursement of funds

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-15
 Activities of Financial Management
Continued
• Risk-return trade-off determined to maximize
the market value
• Influences operational side (capital vs. labor or
Product A vs. Product B)
• Influences financial mix (stock vs. bonds vs.
retained earnings)

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-16
 Figure 1-1 Functions of the
Financial Manager

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-17
 Forms of Organization

• 2017 Tax Cuts and Jobs Act

• Significantly modified taxation for all forms or
organizations
• Corporate tax rate went down from as high as 35
percent to flat rate of 21 percent
• Established 20 percent deduction of qualified business
income from pass through businesses
• Sole proprietorships, partnerships, and limited liability
partnerships are considered pass through organizations

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-18
 Forms of Organization
Continued 1
• Sole Proprietorship
• Represents single-person ownership
• Advantages
• Simplicity of decision making
• Low organizational and operational costs
• Drawback
• Unlimited liability to owner
• Profits and losses taxed as though they belong to
individual owner

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-19
 Forms of Organization
Continued 2
• Partnership
• Similar to sole proprietorship except with two or
more owners
• Articles of partnership specify:
• Ownership interest
• Methods for distributing profits
• Means of withdrawing from the partnership
• Carries unlimited liability for the owners

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-20
 Forms of Organization
Continued 3
• Partnership (cont’d)
• Limited liability partnership
• One or more partners designated general partners and
have unlimited liability for debts of firm
• Other partners designated limited partners and liable
only for initial contribution
• Not all financial institutions extend funds to
limited partnership firms

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-21
 Forms of Organization
Continued 4
• Corporation
• Unique; legal entity unto itself
• May sue or be sued, engage in contracts, and acquire
property
• Formed through articles of incorporation, which
specify rights and limitations of entity
• Owned by shareholders who enjoy limited liability
• Has continual life
• Key feature—easy divisibility of ownership interest
by issuing shares of stock
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-22
 Forms of Organization
Concluded
• Corporation (cont’d)
• Disadvantage
• Potential of double taxation of earnings
• S corporation
• Income taxed as direct income to stockholders, thus
taxed only once as normal income
• Limited liability company (LLC)
• Provides limited liability for the owners
• Can be taxed as sole proprietorship, partnership,
corporation, or S corporation, depending upon
elections made by owners

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-23
 Corporate Governance
• Agency theory
• Examines relationship between owners and
managers of firm
• Identify and reduce potential conflicts of interest
• Institutional investors
• Have more to say about how publicly owned
companies are managed
• Able to vote large blocks of shares for election of
board of directors

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-24
 The Sarbanes-Oxley Act

• Set up five-member Public Company Accounting

Oversight Board (PCAOB) with responsibility for
• Auditing standards within companies
• Controlling quality of audits
• Setting rules and standards for independence of the auditors
• Major focus is to make sure publicly traded
corporations accurately present
• Assets
• Liabilities
• Equity and income on financial statements

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-25
 Goals of Financial Management

• Primary goal—maximization of profit

• Drawbacks
• Change in profit may also represent change in risk
• Fails to consider timing of benefits
• Impossible task of accurately measuring key variable
“profit”
• Problems with inflation and international currency
transactions further complicate the issue

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-26
 Valuation Approach
• Ultimate measure of performance – how
earnings are valued by investor
• Investor will consider
• Risk inherent in firm’s operation
• Time pattern of firm’s earnings increase or
decrease
• Quality and reliability of reported earnings
• Question impact of each decision on firm’s
overall valuation
• If it maintains or increases the firm’s overall value,
it is acceptable
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-27
 Maximizing Shareholder Wealth
• Shareholder wealth maximization is the broad
goal of the firm
• Achieved through high value for the firm
• Long-term wealth is difficult with changing
investor expectations
• Financial problems following 2012 led
investors to remain conservative
• Causing valuations to be depressed from formal
highs
• 2014 investors questioning Dow Jones Industrial
Average highs
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-28
 Management and Stockholder Wealth

• Only way to retain power in long run is by

becoming sensitive to shareholder concerns
• Sufficient stock option incentives to motivate
achievement of market value maximization
• Powerful institutional investors making
management more responsive to shareholders

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-29
 Social Responsibility and Ethical Behavior

• Adopting policies that maximize values in

market
• Attract capital
• Provide employment
• Offer benefits to society
• Certain cost-increasing activities may initially
have to be mandatory rather than voluntary,
to ensure burden falls equally over all business
firms

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-30
 Social Responsibility and Ethical Behavior
Continued
• Insider trading
• Using information not available to public, making
undue profit from trading in company’s publicly
traded securities
• Unethical and illegal practice protected against by
Securities Exchange Commission (SEC)
• Has a negative impact on shareholder’s interest
• Ethical behavior creates invaluable reputation

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-31
 Role of the Financial Markets

• Financial markets—meeting place for people,

corporations, and institutions
• Have either a need to lend, borrow, or invest
money
• Participants can be national, state, and local
governments
• Their markets are public financial markets
• Corporate participants raise funds in
corporate financial markets
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-32
 Structure and Functions of the
Financial Markets
• Distinct parts of financial markets
• Domestic and international markets
• Corporate and government markets
• Money and capital markets

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-33
 Structure and Functions of the Financial
Markets Continued
• Money markets
• Deal with short-term securities with life of one
year or less
• Securities include
• Commercial paper sold by corporations to finance daily
operations
• Certificates of deposit with maturities of less than one
year sold by banks

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-34
 Structure and Functions of the Financial
Markets Concluded
• Capital markets
• Deal with securities that have life of more than
one year
• Long-term markets
• Defined as either 1 to 10 years (intermediate markets)
or greater than 10 years (long-term markets)
• Securities include
• Common stock
• Preferred stock
• Corporate and government bonds

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-35
 Allocation of Capital

• Primary market
• When corporation uses financial markets to raise
new funds, sale of securities made through new
issue is called initial public offering (IPO)
• Secondary market
• Securities bought/sold amongst investors
• Prices of securities keep changing continually
• Financial managers given feedback about firms’
performance

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-36
 Allocation of Capital
Continued
• Return maximization and risk minimization
• Investors can choose risk level that meets
objective, maximizes return for given risk level
• Companies rewarded with high-priced securities
can raise new funds in money and capital markets
at lower cost than competitors
• Firms pay penalty for failing to perform
competitively

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-37
 Institutional Pressure on Public
Companies to Restructure
• Restructuring can result in:
• Changes in capital structure (liabilities and equity
on balance sheet)
• Sale of low-profit-margin divisions with proceeds
from sale reinvested in better investment
opportunities
• Removal of current management team or large
reductions in workforce
• Also includes mergers and acquisitions

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-38
 Internationalization
of Financial Markets
• Allocation of capital and search for lower-cost
sources of financing in global market
• Impact of international affairs and technology
has resulted in need for managers to
understand
• International capital flows
• Computerized electronic funds transfer systems
• Foreign currency hedging strategies

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-39
 Information Technology and Changes
in the Capital Markets
• Cost reduction in trading securities driven down
• Many stock markets and brokerage firms have
merged with domestic and international partners
• Creation of electronic communication networks
(ECNs)
• Has speed and cost advantages over traditional markets
• Electronic markets like NASDAQ have gained
popularity against traditional organized exchanges
such as NYSE

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-40
 Information Technology and Changes
in the Capital Markets Continued
• Retail stock trading allow customers to directly
compete with full-service brokers
• Charles Schwab
• E*TRADE
• TD Ameritrade
• Change to price quotes in decimals
• From the traditional 1/16, 1/8 , 1/4, and 1/2 price
quotes
• Lower-cost environment for customers and a
profit squeeze on markets and brokers
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-41